Adjusting trades that move against you can be hard enough. Choosing how to adjust and when to pull the trigger complicates an otherwise simple trade to start with. Now, throw in an early assignment to the mix, and you’ve got quite the convoluted option trade on your hands. Sounds daunting already doesn’t it? Fear not.
Complicated and complex trades like the one that happened to us in FXI the other month give you a great opportunity to learn and grow as a trader.
On today’s show, we’ll walk through the entire FXI position from start to finish, including all the profit and loss calculations, adjustments, and an early assignment. Lean into this show, and don’t skip it – your future self with thank you for taking the time now so that you don’t have to freak out later when it happens to you.
It’s worth following this episode closely because if you trade long enough, something similar is bound to happen. While most traders would give up when faced with an adjustment and early assignment at the same time, handling this type of trade is not that complicated if you take it step-by-step.
The First Stages of the Trade:
- Let’s rewind time back to April 24, 2020.
- We got into a position in FXI, a China Index ETF, with the assumption that FXI would move sideways.
- The original position was to sell a $38 strike centered iron butterfly. We sold the at-the-money $38 calls and the $38 puts when FXI was trading around 38.18. Then we went out on either end and bought cheap wings for protection.
- We had to go out further on the put side to buy cheap protection. So, the put side spread was much wider than the call side spread. You don’t have to go out the same amount on each end.
- We went out to the $30 strike puts to buy our put protection. These puts cost us 23 cents. On the call side, we went out to the $43 strike, which was only 11 cents. Interestingly, the puts were 23 cents more expensive $8 out, and the calls, which were only $5 out, were half the price at 11 cents. This means that the position had an $8 wing and a $5 wing.
- We made all of these trades for a total credit of $3 exactly.
- To recap, we sold the $38 centered iron butterfly in FXI for a $3 net credit. This means that the lower side risk that we had was $5 (the $8 widespread less the credit that we received of $3). We had $5 of risk or $500 of risk on the lower side. On the higher side, we only had about $200 of risk because the spread was only $5 wide, and we took in a $3 credit.
- We entered the position where the stock was trading right around $38, and we took in a credit of $3, which means our breakeven range is plus or minus $3 from that $38 center strike. In our case, the upper-level breakeven for this position was $41, the lower-level breakeven for this position was $35. So, we had a $6 range of profitability for the stock to trade in, which is quite large since we had a huge volatility event happen just the month before.
- From there, the stock moved roughly sideways as expected, right around the 38-centered strike. We didn’t see an opportunity to take money off the table because we were still so far from expiration. There was not enough of decay in premium for us to take this position off early.
When We Started Thinking about Making Adjustments and Why:
- When we started to get into the month of expiration (June), we began to see the market really take off and run. On the 1st of June, FXI started to run all the way up to around 41-42 from its low of approximately $37 at the end of May. This started to challenge our breakeven position.
- If you’re getting into the month of expiration, you don’t have to make adjustments. Still, it is a good time to start thinking about making adjustments. If your position is being challenged and you’re running out of time, like we were, that is more of a reason to start thinking about making adjustments.
- Think about how you might adjust the position so that you don’t take a full loss. Bad positions can be made profitable, and positions with a big loss can be turned into smaller losses.
How We Adjusted Our Trade:
- On June 3rd, we rolled up our short puts on our iron butterfly in FXI from 38 to 41. That allowed us to collect some additional credit, which was 72 cents of extra credit. That extra credit helped widen our breakeven point by another 72 cents on this position.
Discussion Points Regarding this Adjustment:
- It’s common to move your position on the opposite side of where the market is challenging you. In our case, FXI was moving against our higher strikes, and we decided to roll up our puts.
- We didn’t move our calls at all. If you move the side the market is challenging, you’re moving the side that is already losing, and what’s to say that it won’t continue to move against you? Instead, wait and see if things turn around and come back the other direction first.
- By rolling up our put options on our position, we had the opportunity to collect 72 cents of extra credit. The tradeoff was we reduced the maximum profit we could make on this position down to 72 cents.
- In our original position, on the call side, we had $2 of risk. Now that we had collected an extra 72 cents of premium, we were able to reduce the risk by 72 cents on the call side. Now, our breakeven point was 72 cents higher than where it was before, and we now only have $1.28 of risk. We would lose 36% less if FXI just continued to move higher.
- In exchange for reducing risk by 36%, we had to cut down on how much we were willing to profit on the position by going inverted by $3. Going inverted by $3 means our strikes were an inverse of where they ideally should be. An inversion happens when a short put option is at a higher strike than a short call option. This means that they’re inverted; the new spread can no longer trade for a value less than the inversion width.
- When we go inverted on a position, it’s important that we collect a credit that is more than inversion width. In our case, we had a $3 credit to begin with, which meant that we could go $3 inverted and give up all of our credit if we wanted to lower our risk on the trade. When we adjusted to this position, we collected an extra 72 cents, which means that our total credit on the position was $3.72, but we had to invert our position by $3. That means that we will always lose at least three dollars on the position, which means that our total credit of $3.72, less the width of the $3 inversion, left us with a maximum profit of 72 cents if the stock were to come back down into our range by expiration.
The Ideal Scenario from this Point on:
- Once we had adjusted this position, the goal with the adjustment was to hopefully see the stock come back into our adjusted range, into our inverted range between $38 and $41.
What Actually Happened…
- On June 11, we were assigned early in the morning on our short $38 calls. While this is the ‘hands get thrown up’ moment, what happened shouldn’t actually be that unexpected. The day before, on June 10, the stock was trading up around $41.50. Those short $38 call options were $3.50 basically in-the-money.
- Even though we were assigned those contracts, we decided to hold the remaining contracts from our iron butterfly position and hold the shares.
Two Important Points:
- This position was a covered risk position. Our original position in FXI included a long $43 call option, so we were still protected on the call side.
- Not all assignments mean that the other party is smarter. A lot of people believe that when they get assigned, the other party is smarter. This trade is a case study in the fact that that ideology is not true. It looks like the option buyer is making a good decision by deciding to assign their contracts, and the stock will continue to move higher. But, by that morning, we actually saw that the market was going to go through a pretty big down day.
How We Benefited:
- The option buyer assigned the shares just before a major drop in the FXI. This gave us an opportunity on June 11, the day we were assigned the shares, to remove the entire position for a net profit.
- So, we reduced the risk in case the stock didn’t move into our range by going inverted. The stock ended up moving back into our range, allowing us to take the position off for a profit.
How We Reversed the Inverted Position
- When the stock opened up on the 11th, we were able to reverse the inverted position, which wasn’t as easy as just removing the contracts, because now one of the legs was converted to shares.
- Because we were assigned short stock at $38, the first thing that we had to do was buy back stock to close the short stock position. We did that by buying back shares at $40.36.
- Additionally, we had to buy back our $41 short put option, which we rolled up from $38 to $41 when we went inverted on June 3. We bought back our $41 short puts for $1.25. This means that the net debit that we paid to get out of the position of the short shares and the in-the-money short put was $41.61.
- This might seem confusing, so let’s work out the P&L. We add $0.72 for the credit we earned when we adjusted our position to the original $3.00 credit we had at the beginning of the trade. This is where our position stood before we had to deal with the assignment and start to close out the position.
- Now, we get to where we were assigned short stock at $38. When you are assigned short stock, you don’t buy stock. If you are short stock, technically you sell the stock, and you collect a credit of the stock price. So, we add the stock from the $38 strike call options, which we were assigned to the $3.72 credit from the sale of the iron butterfly and adjustment, leaving us with $41.72. This is our breakeven point.
- Now, we get to June 11, where we could close out the position and buy back the shares to cover the short position. The shares cost us $40.36 each, so we subtract $40.36 from $41.72 on our calculator, leaving us a leftover credit of $1.36.
- Next, we have to remove the short put option position that’s in the money, the $41 short puts. Those puts are trading for $1.25. So, we can buy those back for $1.25 and subtract $1.25 from our $1.36 leftover credit, and we are left with $0.11, $11 of total profit.
- We had two contracts but worked the P&L out with one. We now multiply this by two and get $22 profit.
- The lesson here is not that the trade made a lot of money, but rather that a mindset shift was demonstrated. As a trader, when you go through something like this, it is important to slow your thought process down, to deliberately walk through every step, and think, “Did I collect money? Did I pay money? How does that impact my P&L? What actually happened?” rather than freak out!
Option Trader Q&A w/ Brian
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Brian:
Hi, Kirk. This is Brian from California. I just had a question for you that might be good for the daily call for people with a smaller account, about $8,000, and looking to improve portfolio management. This is regarding IV rank, diversification, and managing between expiration months. Let’s say, hypothetically, you have an iron condor in EWW for a June expiration. Let’s say there’s about 17 days left until that expiration and it’s near the top of the list for IV rank right now on the watch list.
You’re thinking that it’s maybe too late to ladder in for the June expiration with another iron condor staying under the 5% allocation limit for a ticker symbol, so maybe add in another iron condor for July, but you’re getting pretty close to the 5% allocation limit, or do you forget EWW and diversify, start building out July with another ticker symbol that might have a lower IV rank, maybe in the 20s, for example? That’s the question. Just looking for the general approach and a good way to think about it. Any help you can give would be much appreciated. Thank you.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.